AQR Whitepaper 1Q19

Demystifying
Illiquid Assets:
Expected Returns for
Private Real Estate
Executive Summary
The growing interest in illiquid forward-looking yield-based analysis.
assets including real estate means In the process, we explain why naïve
that allocators must carefully comparisons to public counterparts
consider their risk and return. The can be misleading. For institutional
challenge is that modeling private investors trying to calibrate their
real estate is not straightforward asset allocation decisions for private
due to a lack of good quality data real estate, we lay out a framework
and artificially smooth returns. for expected returns, albeit a noisy
We try to demystify the subject one, that is based on a discounted
considering theoretical arguments, cashflow framework similar to what
historical average returns, and we use for public stocks and bonds.

We thank Daniel Villalon, Thomas Maloney, Peter Hecht, Scott Richardson, and
Tobias Moskowitz for helpful comments and suggestions.

Antti Ilmanen, Ph.D.

Principal
Portfolio Solutions
Group

Swati Chandra, CFA

Vice President

Nicholas McQuinn
Associate
Contents
Table of Contents 2

Introduction 1

Frameworks for Expected Returns 2

Conclusion 6

Appendix: Assumptions 7

References 8

Disclosures 9

Table of Contents
 Demystifying Illiquid Assets: Expected Returns for Private Real Estate | 1Q19 1

Introduction

As investors increasingly embrace illiquid While we focus on expected returns, our

private asset classes, they find themselves analysis also touches on the hidden risks
posing the following questions: How much and factor exposures of RE, and accordingly,
should they allocate? What are good yardsticks suggests better comparisons to public
for assessing performance? Are the higher fees counterparts like real estate investment trusts
of illiquid assets justified by higher expected (REITs). The reported volatility and equity
returns over public markets? How can one beta of private assets tend to be understated
assess their risk and diversification potential? unless one desmooths their returns, which
may not be a clear-cut exercise. This makes
The comparison to public assets is not their diversification potential or naïvely
straightforward. Illiquid assets are inherently measured alpha overstated. Even if one
harder to model, and this is exacerbated by expected RE to provide zero excess return
a lack of good quality and transparent data. over REITs, the assumption that RE was less
We try to demystify the subject, focusing on risky, and significantly less correlated to public
the medium-term expected return (ER) of equity, would call for an increased allocation
private real estate (RE), while a companion to RE.
piece focuses on private equity.1 We view
the topic from multiple lenses: theoretical We estimate medium-term expected returns
required returns, historical performance, and for U.S. private commercial real estate, as
finally our favored approach of extending represented by the NCREIF indices.2 We
our discounted-cashflow-based (DCF) caveat that returns for individual RE funds
methodology for equity and fixed income to can vary vastly from the industry average,
the realm of RE. due to a wide dispersion of returns by
geographic region, sector, and manager.

1  See Ilmanen et al. (2019).

2  NCREIF offers two quarterly indices. The first is the NCREIF Property Index (NPI) which is appraisal-based. The second is the NCREIF
Transaction Based Index (NTBI) which is transaction-based and includes only NPI properties sold during the quarter.
2 Demystifying Illiquid Assets: Expected Returns for Private Real Estate | 1Q19

Frameworks for Expected Returns

As in the companion piece on private al. (2015) indicate that, as an asset class, real
equity, we approach the topic through three estate is pro-cyclical and growth-sensitive.
complementary perspectives described in Thus, real estate can be viewed as a levered
Ilmanen (2011): theoretical required returns, combination of equities, fixed income,
historical evidence on past average returns, real estate specific factor(s), and a possible
and yield-based analysis that considers illiquidity premium.
current valuations and market conditions.
What factor tilts can we expect RE to have
As is the norm with other asset classes, we over publicly traded real estate investment
present real (inflation-adjusted) compound trusts (REITs)? First, in principle, RE should
rates of return for the asset class as a whole command an illiquidity premium over REITs.
for a horizon of 5 to 10 years. Over such But as we show later, several empirical
intermediate horizons, initial market yields studies have found none.3 Second, REITs
and valuations tend to be the most important should be more equity-like and have more
inputs. For multi-decade forecast horizons, equity exposure than RE. Thus, perhaps
the impact of starting yields is diluted, so the illiquidity premium of RE is offset by
theory and long-term historical average the equity beta premium of REITs? But we
returns (or yields) may matter more in remind readers that the reported returns of
forecasting expected returns. Our estimates RE are artificially smoothed, leading to an
are intended to assist investors with their understatement of its true risk and equity
strategic allocation and planning decisions, beta when using naïve measures. Shepard et
and, in particular, with setting appropriate al. (2015) observe that once private real estate
medium-term expectations. They are highly returns are desmoothed, their correlation to
uncertain and are not intended for market equities is 0.66, only slightly lower than the
timing. The framework may be more useful 0.82 correlation of REITs to equities. Further,
and informative than the numbers themselves. on desmoothing RE returns, the correlation
between REITs and RE, too, increases to 0.77.
Theory
The daily correlation between RE and REITs
Real estate returns have two components. may be misleadingly low as RE does not
The first is a steady income component from reflect mark-to-market fluctuations. But over
rental leases, akin to the periodically reset the long run, RE and REITs are more highly
coupon on an inflation-linked bond (though, correlated due to their common economic risk
as we mention in the Appendix, real estate is and growth sensitivity. Assuming that RE
an imperfect inflation hedge). The second is a has no illiquidity premium to REITs and that
considerably more volatile price appreciation RE fees offset any alpha, a theoretical public
component, which, like equities, is driven by proxy approach suggests that the expected
changes in growth expectations. Shepard et return for REITs might be a reasonable

3  See Pagliari et al. (2005) and Ang et al. (2013).

 Demystifying Illiquid Assets: Expected Returns for Private Real Estate | 1Q19 3

proxy for the net-of-fee expected return RE and REITs needs to be adjusted for the
for RE, provided one adjusts for leverage, different leverage and sector compositions
industry, and geographic composition. of the indices. As NPI and NTBI returns
are reported on an unlevered basis, they
Historical Performance
are lower in magnitude than REIT returns.
Oddly enough, in North America, REITs have Exhibit 1 shows the historical performance
outperformed RE by 1-3% since inception, of RE and REITs, before and after making
suggesting an inverse illiquidity premium. 4
them more comparable.5 After adjusting for
leverage and sector, the inverse premium
As we stressed in our companion piece on almost disappears, but we still see no
private equity, the choice of benchmark is positive illiquidity premium. This is in line
critical. The naïve comparison between with the findings of Pagliari et al. (2005).

Exhibit 1
Private vs. Public Real Estate: Returns Comparison Before and After Adjustments
for Leverage and Sector Composition
April 1, 1980 – December 31, 2012
15% 14.0%
Annualized Average Return

10.2%
10%
8.4% 8.3%

5%

0%
Unadjusted Comparable Comparable Comparable
REITs (Unlevered, NCREIF NTBI NCREIF NPI
Sector-Adjusted)
REITs

Source: AQR, Ang et al. (2013). Available history starts in Q2 1984 for NTBI and Q2 1980 for other series. All series end
in Q4 2012. The REITs series is the CRSP/Ziman Real Estate data series. Returns are annualized from the quarterly returns reported
in Ang et al. (2013). Returns are gross of fees, cash, and t-costs. For illustrative purposes only and not representative of any portfolio or
strategy that AQR currently manages. Please refer to footnote 5 for more detail.

4  Source: Bloomberg. Using arithmetic (geometric) means, the FTSE NAREIT All REITs index has outperformed RE indices, namely, the
NCREIF NPI by 2.9% (1.6%) and the NTBI by 1.8% (1.0%) annually since their respective inception dates of 1978 and 1984.
5  To construct a comparable REIT return series, Ang et al. (2013) unlever the monthly returns of REITs in the four core property types
(apartment, retail, office, and industrial) that are common to NCREIF. They then adjust the REIT returns to have the same sector
weights as the NPI and NTBI indices (second bar in Exhibit 1). To construct comparable NPI and comparable NTBI returns (last two
bars in Exhibit 1), they exclude hotels from the NPI (hotels are excluded from the NTBI). As both the NPI and NTBI are unlevered by
construction, no leverage adjustment is necessary.
4 Demystifying Illiquid Assets: Expected Returns for Private Real Estate | 1Q19

Digging deeper into historical valuations, we sharply during the Global Financial Crisis as
see in Exhibit 2 that real estate exhibits the prices plummeted. Of note, NCREIF cap rates
trend of richening valuations and decreasing are highly smoothed and considerably lagged
yields we see in equities and fixed income, versus NAREIT cap rates, pointing to the stale
with NCREIF yields currently at an all- pricing and artificial smoothing inherent in
time low. Exhibit 2 plots the cap rates, or
6
RE appraisals. Exhibit 2 shows that in recent
Net Operating Income (NOI) yields, for the years, RE cap rates have declined compared
NCREIF and NAREIT indices. Both indices to REITs; that is, RE has richened relative to
exhibit similar patterns. During the boom- REITs. If valuations are an indicator of future
and-bust cycle of the 2000s, yields declined returns, that suggests RE may deliver lower
as prices appreciated steadily, and then rose returns than comparable REITs in the future.

Exhibit 2
The Valuation Gap between Private and Public Real Estate
January 1, 1994 – June 30, 2018

11%

10%

9%

8%

7%

6%

5%

4%
1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017

REIT Cap Rates NCREIF Cap Rates (All Property Types)

Source: NCREIF, CoStar Portfolio Strategy. Data as of June 30, 2018. The implied cap rate for REITs is the implied unlevered cap rate of the
FTSE NAREIT index. For illustrative purposes only and not representative of any portfolio or strategy that AQR currently manages.

6  NCREIF yields in Exhibit 2 as of June 30, 2018. Also, see AQR Alternative Thinking Q1 2018: Capital Market Assumptions for yield-
based expected returns and historical yields for U.S. equities (S&P 500) and fixed income (10-year U.S. Treasuries).
 Demystifying Illiquid Assets: Expected Returns for Private Real Estate | 1Q19 5

Yield-Based Approach for equities, where we sum payout yield and

expected long-term growth rates to derive ER.
Real estate can be characterized by a relatively Exhibit 3 depicts the building blocks of our
steady income component and more volatile approach for RE. We provide detail on our
price appreciation. Our yield-based approach assumptions in the Appendix.
for RE is similar to our DDM-based approach

Exhibit 3
Real Expected Returns for Private Real Estate
As of September 30, 2018

NOI C= NOI / 3 CF ≈ NOI - C g ER = CF + g

Cashflow Real Unlevered
NOI Yield CapEx Yield Growth Real ER

Current 4.4% – 1.5% ≈ 2.9% + 0.0% = 2.9%

Source: AQR, NCREIF Webinar Q3 2018. NOI Yield from NCREIF as of September 30, 2018. For illustrative purposes only and
not representative of any portfolio or strategy that AQR currently manages.

• Yields: The payout or free cashflow on • Multiple Expansion: As is our general norm
RE is the net operating income (NOI) with most asset class expected returns, we
generated by a property (for example, assume no reversion in multiples.
rental income) minus the capital
expenditure required to maintain the Putting this together gives us a gross real ER
property. As shown by Pagliari (2017), of roughly 3% for unlevered RE. We report
this capital expenditure has averaged unlevered ER to make it comparable to the
around a third of the NOI. Thus, RE free unlevered returns reported by NCREIF, but
cashflow yield can be approximated as caveat that the actual levered ER could vary
two-thirds of NOI Yield (NOI / Market vastly with the leverage employed in the RE
Cap). As of September 30, 2018, the fund. This is roughly on par with our gross real
NCREIF NOI yield was roughly 4.4%, ER estimate of 2.7% for a U.S. 60/40 portfolio
leading to a free cashflow yield of 2.9%. (4% for U.S. equities, 0.7% for U.S. 10-year
Treasuries). We expect the (desmoothed)
• Growth Rates: We expect that on average, volatility of RE to be slightly higher (roughly
the long-term growth rate in real estate 11% for unlevered RE) than the volatility of
cashflows should equal inflation; i.e., the a 60/40 portfolio (roughly 9%), indicating a
real growth rate in earnings is zero. Sharpe ratio of around 0.3 for both.7 In other
words, risk-adjusted returns are in-line, too.

7  U.S. 60/40 portfolio ER estimates as of September 30, 2018. U.S. equities represented by the S&P 500, fixed income represented
by U.S. 10-year Treasuries, and the risk-free rate represented by the expected return on 3-month U.S. T-bills. See AQR Alternative
Thinking Q1 2018: Capital Market Assumptions for further details on methodology. As RE data is available only with a meaningful lag,
it is debatable whether the most relevant comparison is to contemporaneous public market yields.
6 Demystifying Illiquid Assets: Expected Returns for Private Real Estate | 1Q19

Conclusion

In this article, we present more comparable deal of uncertainty, and our framework is a
benchmarks or suitable adjustments for work in progress that we may fine-tune in the
evaluating the past performance of RE, future. We hope it is a first step toward a more
and a yield-based framework to estimate intuitive and transparent comparison between
future returns. We humbly admit that return public and private assets.
estimates for any asset class come with a great
 Demystifying Illiquid Assets: Expected Returns for Private Real Estate | 1Q19 7

Appendix: Assumptions

Here, we expand on the assumptions for expected returns that were summarized in
the main body:

• Yields: The rental income on a property can be measured by its Net Operating Income
(NOI). But NOI overstates the net cashflows that investors receive, as it does not deduct the
recurring capital expenditure required to simply maintain real estate. Pagliari (2017) finds
that over the long-run, this recurring expense has averaged one-third of NOI, though it
varies per RE sector. Thus, cashflow yield can be approximated as two-thirds of NOI Yield
(NOI / Market Cap).

• Growth Rates: Pagliari (2017) finds a negative long-term real growth rate in earnings for
RE.8 RE has turned out to have an imperfect inflation pass-through rate (roughly 0.67); that
is, earnings have not kept up with inflation. We can contrast this finding with some evidence
that rental income may grow in tandem with GDP-per-capita and population growth, at a
modest positive real rate.9 We take the middle ground and expect that on average, the long-
term growth rate in real estate cashflows should equal inflation; i.e., the real growth rate in
earnings is zero.

• Multiple Expansion: We assume no reversion in multiples. The long-run evidence on home

price appreciation (which excludes rental income) is disappointing. The Case-Shiller Home
Price Index (which reflects residential real estate only) shows that U.S. home prices barely
kept up with inflation over the long run since 1890, though readers may recollect only the
more recent bubble during the 1990s and the bust during the financial crisis.10

Looking at broad historical evidence beyond commercial real estate, a recent study by Jordà
et al. (2017) documents unusually high long-run returns for housing, driven both by a high
rental yield and positive price appreciation. However, these appear to be overstated for several
reasons.11 Among the critics of this study, Dimson et al. (2018) find a long-run average real home
price appreciation of 0.3% in the U.S. and 1.3% across 11 countries. Notably, when adjusting the
series for quality improvements and home expansions, they find a negative real growth rate of
-2.1%. Again, we remind readers that there can be a wide dispersion in price appreciation, based
on geographic region, RE sector, and time period.

8  This is the per-property growth rate as calculated by NCREIF, not growth in the aggregate index. This is analogous to the per-share
growth rate in earnings that accrues to existing shareholders, as opposed to growth in aggregate GDP.
9  Takáts (2010) estimates that both real GDP-per-capita growth and total population growth boost real house prices one for one; that is,
a 1% increase in either series raises real house prices by 1%.
10 The Case-Shiller Home Price Index reflects a 0.4% real price appreciation over the period 1890 to 2017. As Ilmanen (2011) reports,
this surprising finding is consistent with the fact that housing in a great location like Manhattan (Amsterdam) barely maintained its real
value over 100 (400) years.
11 Jordà et al. (2017) report that U.S. housing achieved a long-run nominal total return of 11.1%, including 7.6% rental income and 3.5%
price appreciation, over the period 1891 to 2015. This is roughly on-par with their nominal total return for equities of 11.1% over the
same period. Their rental yield estimate may be overstated if it did not deduct expenses for regular capital expenditure.
8 Demystifying Illiquid Assets: Expected Returns for Private Real Estate | 1Q19

References

Ang, A., Nabar, N., Wald, S. (2013). Searching for a Common Factor in Public and Private Real
Estate Returns, SSRN working paper.

AQR (2018). Alternative Thinking Q1: Capital Market Assumptions.

Dimson, E., Marsh, P., Staunton, M. (2018). Credit Suisse Global Investment Returns Yearbook
2018, Credit Suisse publication.

Ilmanen, A. (2011). Expected Returns: An Investor's Guide to Harvesting Market Rewards,

Wiley.

Ilmanen, A., Chandra, S., McQuinn, N. (2019). Demystifying Illiquid Assets: Expected Returns
for Private Equity, AQR whitepaper.

Jordà, Ò., Knoll, K., Kuvshinov, D., Schularick, M., Taylor, A.M. (2017). The Rate of Return on
Everything, 1870-2015, NBER working paper.

NCREIF Webinar Q2 2018, Q3 2018.

Pagliari, J.L. (2017). Some Thoughts on Real Estate Pricing, Journal of Portfolio Management 34
(6), 44-61.

Pagliari, J.L., Scherer, K.A., Monopoli, R. T. (2005). Public versus Private Real Estate Equities: A
More Refined, Long-Term Comparison, Real Estate Economics 33 (1), 147-187.

Shepard, P., Hobbs, P., Liu, Y. (2015). Is Real Estate Bond-Like?, MSCI Research Insight.

Takáts, E. (2010). Ageing and Asset Prices, Bank for International Settlements working paper 38.
 Demystifying Illiquid Assets: Expected Returns for Private Real Estate | 1Q19 9

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